Wednesday, August 5, 2009

Ethics, journalism, the web and the profits of brokerage businesses – oh, and Paul Krugman

Tyler Durden of Zero Hedge has responded to this blog post - and his comments - which I should fairly highlight - are reported at the end.

One of the perils of having public opinions is that people publicly misquote or misrepresent you.

My first introduction to Talking Points Memo was a Muckraker column which erroneously attributed offensive views about Sheila Bair to me.I dislike Sheila Bair intensely but the views in the muckraker column were not my views.The whole issue was solved with an email.Within 30 minutes TPM corrected their post and posted an apology.No harm was done.The amended TPM post can be found here.The original post is (fortunately) lost to the web and I can’t even find it in the Google archive.

The web (and blogging in particular) allows you to do this – to shoot from the hip and to correct where appropriate.Sometimes the correction should be total withdrawal of the offensive idea (as TPM did) – the test being about defamatory and clearly incorrect.Mostly it should be additional notes or follow up posts describing the world as nuanced.

At the moment I am having trouble with Julian Delasantellis who hails from America but writes for the Asia Times.The Asia Times describes him as “an educator in international business from the US State of Washington”.

His quote about me is as follows:

“John Hempton of the Clusterstock blog suggests that Goldman is brokering sovereign wealth fund (SWF) purchases of US and British debt securities, but it is doubtful that the sharp operators running the SWFs would be leaving this many crumbs on the table.”

Alas I never said anything of the sort.The original Clusterstock article is here and you can compare yourself.I want to correct Mr Delasantellis because it gives me an opportunity to explain to a wider audience the way I believe the broking industry really makes its profits…

I have always thought the trading profits come from intermediation and not from broking.My view: traders at a desk sit all day and see prices (or create them by finding suckers to hold their residual risks).They see if they go long this exotic piece of debt (say a mortgage instrument or a corporate), buy a credit default swap (and hence pass the risk to someone who is sometimes a sucker), hedge out the interest rate risks (with swaps mostly) and fund the entire thing by going short a Treasury bond then they can make an “arbitrage profit”.What they have done though is funded exotic debt (mortgages, corporates etc) by increasing the supply of vanilla debt (treasuries).

They could do the trading either way – they could buying the Treasuries and shorting the corporate debt – however the market is biased one way – it is biased to make profits by going long exotic, hedging and shorting Treasuries.

The reason why it is so biased is that there is in the world a huge demand for vanilla debt (as the Chinese and others want to own Treasuries) and a huge supply of exotic debt (because the spendthrift in English speaking countries and Spain keep borrowing to fund housing and their lifestyles).

The investment banks – through their trading books – at least in part – intermediate the current account deficit.That is the main source of the risks I think investment banks are taking and where the “trading” profit comes from.I thought – and still think – that high frequency trading is a distraction (even though it imposes a small tax on many market participants).

I have written about broker profits extensively on my blog trying to quantify the intermediation profits (only partially successfully). Here are links to the main series (see Part 1, Part 2 and Part 3).

The balance sheets of the investment banks have got so huge (cumulatively about 6 trillion dollars last time I aggregated them) precisely because there is so much intermediation to do. Brad Sester used to “follow the money”, I tried to work out the mechanisms by which they money flowed that way.

Julian Delasantellis through misrepresenting my views established me as a straw man who he could demolish in a single sentence.This enabled him to (incorrectly) argue that a high degree of Goldman Sach’s profits come from high frequency trading.

He has refused to issue a correction because he has refused to undermine his own argument.Talking Points Memo was quick to issue a correction – where as Delasantellis was not.The ethical thing to do would be to clearly amend the paragraph and write a short note at the end of the web article.In this case I can’t tell whether Mr Delasantellis’s apparent lack of ethics reflects insecurity or incompetence.Whatever – it clearly illustrates how – without high ethical standards – faulty arguments get made and amplified by the media.

But the whole high frequency trading debate has had that character.What has happened is that a consistent campaign by an anonymous blogger taking the name of Brad Pitt’s Fight Club character (Tyler Durden) has managed to elevate high frequency trading from a fringe activity (although one that does impose costs on ordinary investors) to the centerpiece of Goldman Sachs control of the universe through market manipulation.Weirdly he has widespread acceptance of that view – and a consistent web campaign has actually got US Senators interested and the SEC wanting to clamp down on some of the practices.

I suspect that these campaigns can be successful because (a) there is a predisposition to think that all that Wall Street does is evil and (b) the quality of financial journalists is on average low (with Mr Delasantellis just being an extreme example).

Contra:even Paul Krugman however (a man with very high standards) has jumped on the high frequency trading bandwagon – but to give Krugman his due he has reread one of the many brilliant articles by Kenneth Arrow and pointedly not given any quantification of how big an issue it is.

A rare economic experiment

Now we have one of those rare experiments in economic punditry.Goldman Sachs has issued a statement that says high frequency trading is less than 1 percent of Goldman’s revenue and less than one percent of their capital employed.That of course translates as “banning it would have no material effect on Goldman’s profits”.And due to the successful campaign by “Tyler Durden” much of the abusive high frequency trading looks like it will be banned.

If – ex post – Goldman’s profits do not take a catastrophic hit on the ban then hey – the whole HFT thing was (as I suspect) a storm in tea-cup.Krugman’s refusal to quantify will be endorsed and Mr Delasantellis will look like the fool he appears to me to be.

But the experiment could pan out the other way – in which case you will see this blog clearly state the mistake I have made.

However this is not to gloat about formalised economic experiments (rare and exciting though they may be).There are huge risks in the balance sheets of investment banks – as the world found out when Lehman Brothers failed.Unless we understand those risks we do not know how to control them.Once in the last 100 years we had major financial re-regulation in response to an economic calamity – and much of the Great Depression legislation has served us well (see this example – Part I and Part II).

We have another once-in-a-lifetime opportunity to get this right – and the high frequency trading debate has wasted precious time, precious column inches and hence part of that precious opportunity.

So I will reissue my plea – can we get the debate focussed back on what really matters.

John

PS.I have no idea as to whether Tyler Durden and his Zero Hedge blog represents the lobbying efforts of a traditional market maker.But competition from high frequency trading has slashed market making margins and regulators are rushing to reassert the old status quo.An anonymous blog consistently pushing an economic issue (any issue) deserves to be treated with far more skepticism than Zero Hedge has been met with.Very well executed anonymous blogging (and Zero Hedge is a great blog) might turn out to be very effective lobbying.

PPS- Tyler Durden has responded to this blog post - here are his comments...

Ethics, journalism, the web and the profits of brokerage businesses - oh, and Paul Krugman (Bronte Capital) - John, I can put it on the record that Zero Hedge represents no lobby interests and has never received any compensation either direct or indirect in its fight for market transparency, and stands to benefit in no way from the market topology either changing or staying the same (aside from the 0.5% of total market cap price I pay for liquidity any and every time i trade a stock, and which fee, which I disclosed in my observations on Implementation Shortfall, you failed to bring up in your cost-benefit analysis, and whose bottom line as to liquidity costs is dramatically different from your figure). While I am sure you can provide the same disclaimer, to say that a simple blog can dictate policy is a little far fetched (also, not sure how your journalistic colleagues feel about your condesending opinion of them, who, by your statement is a virtual majority, of everyone out there). Or maybe not, if your null assumption is that regulators were letting illegal activities go on for years and are now backpedalling once someone dares to shine some light. In fact, once Flash Trading is done away with, Zero Hedge is fully intent on exposing Dark Pools for the opaque, "liquidity providing" yet liquidity fee gobbling, IOI-based machinations they really are. Oh, and as a total aside, Goldman's record $100MM+ trading days in Q2, and Medallion's 40% compounded returns since inception at a 5.0 SIGMA (I am sure you understand what that means) - that's totally unrelated to HFT as well.

My comment on Tyler's comment:

I am entirely convinced that Goldman's returns do NOT come from high frequency trading. However I am far less convinced of the source of the Medallion returns. Renaissance Technologies does have fantastic returns - and nobody seems to understand where they come from - and they DO trade a lot.

I note however that Renaissance Technologies returns have dropped dramatically in the past year - and many (including me) have speculated it is because algorithmic trading of all kinds is subject to far greater competition. More competition usually lowers profits.

The argument that Goldies blowout trading profits have been caused by their recent forays into high frequency trading is absurd. Everyone I know of who has hugely electronic trading systems is making less money - not more - and they are making less money for the entirely expected reason - which is competition.

Finally - yes I think the majority of business journalists are dreadful - at best parroting the received opinion of the day or corporate press releases. There are some very noble exceptions - Peter Eavis (WSJ), Bethany McLean (Vanity Fair), Joe Nocera (NYT) spring to mind. These journalists have done outstanding work - and Nocera wrote one of my all time favourite books. But yes - business press is difficult to read for a reason - which is that the standards on average are low.

That I should be criticised for arguing that business journalism is on average a low standard is comical. Six hours watching CNBC will convince you of that. Or Fox business, or reading the business section of any major local newspaper. Quality business journalism is really hard and few do it well - though the reporters mentioned in the last paragraph do it very well indeed. The reason it is hard is that everyone has a vested interest and the stories are often complicated.

The low standard of business journalists is one reason why fine blogs (like Zero Hedge) are worth so much time - even when I do disagree with them. Some of the best journalists are also bloggers (Felix Salmon for instance).

10 comments:

Asia Times is a notoriously flakey online source of 'news and analysis'. In reality, the publication has minimal full-time staff and takes copy from all and sundry because it does not have the budget to pay a proper newsroom. The upshot is a significant chunk of its reporters are substandard and have a particularly poor grasp of business, finance and economics. For further awful examples of AToL reportage check here for a good takedown of Atol's 'business journalism' (particularly amusing if you read the article is the self-styled description of the author - I doubt he worked at McKinsey or BCG) and here.

What about the issues of the big HFT firms being able to manipulate markets on low volume days and the allegation that HFT only provides shallow liquidity and could cause market disruptions in times of heavy stress

Another excellent post, thank you for the very clear explanation of intermediation of the current account deficit.

I do have one point I'd like to discuss where I don't agree with you.I still don't get the comment that hft causes a small tax on market participants. The HFT I know about makes prices slightly more accurate given what's knowable at the time. This has benefit to all market participants, buy and sell, and yes, collecting and correctly processing the information required to make prices more accurate costs money, and the people that do it charge for their services. But the charge is very indirect, it's paid only when a high frequency trader is correct on average in his evaluation of (and action upon) noisy, price-moving information. It's a risky, difficult business but it ultimately provides something the market is willing to pay for, as the market self-organizes for its own survival. "Tax" is not what I would call the market participant's payments for better prices. It's payment for valuable information.

1. GS could have swings in p/l unrelated to HFT. eg: They could post a loss next quarter b/c of another area. It's difficult to prove or disprove the impact of this flash order ban on GS's p/l one way or another. (But I bet you are right and it is a small contributor)

2. I agree 100% w/Anon @12:07 above. HFT can be argued to provide you with far more benefit than cost.

3. What is HFT? I've heard people describe HFT as stat-arb books that trade several times an hour, mm systems, basis traders, etc. HFT is about as specific as saying "traders do x".

Very nicely spelled-out and reasoned--thanks for making the effort. Too many people seem to have a hard time understanding the difference between disagreeing with someone and launching a personal attack on their morality/intelligence.

I, too, was struck by the speed at which Zero Hedge was able to make the HFT issue relevant to the policy makers (Yves Smith has a fabulous post on the legislative process in DC today, BTW). If an anonymous blogger can short-circuit the hearing/lobbying/horestrading that surrounds the Congress and get someone to move on this then it is a new day--and perhaps a better one (though that all depends on the blogger). What it does indicate is how sensitive GS et al. are to any kind of public criticism right now, and how desperately some public "servants" are looking for someone to blame this once and future mess on.

You really need to take a much closer look at Goldman's role as a sole supplemental liquidity provider with the NYSE. Then take a close look at how much principal volume they make up in the weekly NYSE program trading reports.

Goldman made more money in trading the fixed income markets in 2Q, as they've been able to rake both sides of the spread trade-- so you are partially correct. It helped that most of Goldman's competition (Bear and Lehman) somehow "disappeared" last year.

But don't think for a second that GS isn't benefiting from HFT. They are-- whether it's through "liquidity rebates", or through half penny profit spreads they are extracting from their clients.

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. You should assume Mr. Hempton and his affiliates have positions in the securities discussed in this blog, and such beneficial ownership can create a conflict of interest regarding the objectivity of this blog. Statements in the blog are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. Certain information in this blog concerning economic trends and performance is based on or derived from information provided by third-party sources. Mr. Hempton does not guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Such information may change after it is posted and Mr. Hempton is not obligated to, and may not, update it. The commentary in this blog in no way constitutes a solicitation of business, an offer of a security or a solicitation to purchase a security, or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.